Season Investments

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Bubbles!

Posted on April 25, 2017

“A bubble is a psychological phenomenon that occurs when an asset class becomes overvalued and is accompanied by an obsession or preoccupation with that asset class.” – Jared Dillian

2017-04-25_Bubbles.jpgIf you are an investor, you are most likely familiar with the term “bubble” as it pertains to investing. Twenty years ago this was not the case, but today we are all too familiar with the term. A housing and two stock market bubbles here in the US in the past two decades will do that for you. Leading up to this century, not many investors were familiar with term economic bubble. The problem we now face is that everyone is hyper-aware of bubbles to a point where there is a bubble boogeyman around every corner!

Now to go on record, we are acutely aware of the existence and proliferation of investment bubbles, which we have written about several times on this blog in the past (Are We In Another Housing Bubble?, Is Bernanke Blowing A Bubble?, Swimming Naked). Quoting myself from our most recent bubbly post:

[T]he logical outcome from uber-Keynesian central bank policy which attempts to steer markets through top-down intervention is dislocations in free market pricing…also known as bubbles. So even though we don’t believe the aggregate US housing market is currently in a bubble, we are fully aware that bubbles are much more commonplace today than they have been in the past.

But just because bubbles are more commonplace today than they have been in the past, doesn’t mean that every bull market is an investment bubble. We have all been scarred by multiple bubbles in the past two decades, which is why we are so quick to call every bull market a bubble today. Sometimes it feels like every market pundit and participant is acting like Nemo’s fish tank friend (aptly named Bubbles) in the embedded clip who is fascinated with BUBBLES!

Many assets today can easily be considered overvalued by historical standards but overvaluation does not necessitate a bubble. The big difference between the two is the level of preoccupation with the investment in question as Jared Dillian aptly points out in the opening quote.

My first experience with an investment bubble was the tech bubble in the late 90’s. I was in college at the time and brand new to investing. The problem was that, along with everyone else, everything I was investing in was going straight up as the rising tide was lifting all boats. I felt invincible and was fairly convinced that I was a genius investor. It didn’t take long to learn that neither were even close to true. All the gains I accrued during the go-go years of the late 90’s quickly evaporated and then some (leverage will do that to you) once the tech bubble finally burst in the spring/summer of 2000. During the run up in the late 90’s, everyone was talking about and totally preoccupied with the stock market (tech stocks in particular). The fact that a college kid was trading options and buying tech stocks on margin from his dorm room is a fairly good indication that there was a bubble at hand.

Another example of a bubble, which isn’t talked about as much but actually occurred around the same time, was the Beanie Baby hysteria. Some of you may not remember and others may remember all too well how obsessed some people got with Beanie Baby toys in the late 1990s. In fact, a detective went on record to describe a murder he was investigating as a “Beanie Baby deal gone bad.” The picture below (taken from the linked Slate article) is of a couple who were seeking a divorce and were unable to split up their Beanie Baby collection without the supervision of the court. Some people were buying and selling rare Beanie Babies, which originally sold for $5 at the store, for upwards of $5,000 on eBay with the idea that they would be worth even more money in the future! To say that a sub-set of people were totally preoccupied (our litmus test for an economic bubble) with Beanie Babies during this time would be an understatement. Like all good bubbles, the Beanie Baby bubble eventually popped and today those rare toys sell for less than what you probably have in your wallet.

150203_SCI_BeanieBabyDivorce.jpg.CROP.promovar-mediumlarge.jpg

Contrast that kind of crazed hysteria with today’s market environment. Even though various asset classes continue to make all-time highs (including the US stock and real estate markets), you don’t hear your dentist, mechanic, or hairdresser all talking about them unless it is in the context of how those markets are in a bubble (the opposite of hysteria).

In fact, the level of preoccupation with most well-known, global asset classes is relatively low right now because most people are still scarred from the last go around. Unfortunately, this attitude is fairly counter-productive when it comes to investing. We’ve all learned the valuable lesson that the herd mentality and euphoria over any particular investment can lead to large losses, but in doing so, we’ve swung too far in the other direction and thrown the baby out with the bathwater. In the same way we want to guard against emotional decision making that causes us to “press the bet” in the last leg of a market cycle or investment bubble, we also have to guard against emotional decision making driven by fear which keeps us from profiting during a bull market in asset prices.

One of the consequences of the financial crisis is that any time the price of anything goes up, anywhere, we think it is a bubble. We have been psychologically scarred.  We will always confuse legitimate bull markets with bubbles. – Jared Dillian

To combat this pendulum swing of emotional decision making, we have adopted a mathematical approach to investing using a simple trend following technique which we developed in house and have branded MarketVANE. We like to explain it in terms of a stop light. If the intermediate term (6-9 months in our case) trend is strong, MarketVANE will be on a green light and we will be fully invested to each client’s investment target in growth/risk assets (stocks and hard assets). When the trend starts to break down in a choppy or a sideways market, MarketVANE will switch to a yellow light and we will “take chips off the table” by reducing the allocation and holding more cash. Finally, when the trend breaks down entirely in a falling market, MarketVANE will turn to a red light and we will hold cash in lieu of the target allocation.

The beauty of this rather simple discipline is that it is just that…disciplined. It takes the emotional guess work out of trying to spot the next bubble and allows us to take advantage of long-term bull markets. Now I will be the first to tell you that no system is perfect and trend following is no exception, but it is one that we have embraced primarily because it addresses the cost of being human and increases the probability that our clients will stick with their long-term investment approach rather than making an emotional decision in the throngs of the next bear market. Having a trend following discipline like MarketVANE in place is akin to investing with an airbag, which allows you to ride long-term bull markets without looking for the bubble boogeyman around every corner.


elliott_headshot_bw.jpgAuthor Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.


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